Traders
on the main trading floor of the New York Stock Exchange early in
the trading session in 2008.Mike
Segar/Reuters

Wall Street banks require major surgery.

The slump in several key businesses this year — from trading to
deal underwriting — has been well documented.

But a new study on the industry, from the consulting group
McKinsey, points to a much longer-term problem with their
performance — and specifically with their cost structure.

It makes for grim reading.

The top 10 banks posted a combined return on equity, a key
measure of performance, of 7% in 2015, according to McKinsey.
That's below their cost of equity, which is thought to be about
10% to 12%.

It means the industry at large is destroying value rather than
creating it. Returns are being dampened by both rising costs and
lower revenues. Banks are also required to hold on to more
capital — funds that otherwise could be invested and potentially
increase profits — because regulators are looking to make the
banking system safer.

"Many banks will need to undergo transformative change to
transition to a successful operating model, scaling back their
aspirations for their capital markets and investment banking
businesses and reducing their product set, client mix and
regional footprint, accompanied by a commensurate change in their
cost structure," the report said.

McKinsey

Now you might be wondering how costs increased. Aren't banks
constantly cutting staff?

They are indeed cutting headcount, with the top 10 banks
eliminating more than 10,000 front-office jobs since 2011,
according to Coalition. That isn't having that much of an
impact on costs, however, with the ratio of costs to income
barely moving.

Here's how McKinsey explains it (emphasis added):

"Crosscurrents have impeded progress, as banks have sought to
disentangle complex global operations. Cost cutting in technology
and support functions has been particularly challenging, with
platforms often deeply embedded and decommissioning programs
tending to run over long periods.

"In addition, banks often take a front-office view on
restructuring and cost-cutting, e.g., they try to reduce costs
but salvage as much revenue as they can, often preserving the
option to return to a business when conditions improve. Managers
making these decisions are often incentivized by revenue targets
and do not always fully understand the downstream cost
implications. When a trading desk is closed,for example, its supporting technology may be necessary
for other parts of the franchise, leading to a smaller revenue
base supporting the same level of fixedcosts. The economics of this scenario and the
stranded costs are sub-optimal."

In other words, even if a bank cuts jobs, there are some costs
related to those roles that it can't get rid of. So all it has
really done is kill off a source of revenue and shift the burden
of covering expenses onto a smaller group of people.

This is most noticeable in fixed income, currencies and
commodities. FICC headcount at the top 10 banks is down by a
third since 2010, according to McKinsey, but, as per the chart
below, FICC costs are down by only 16%.

So what to do?

If cutting jobs won't do the job, how are bank executives to cut
costs?

McKinsey's answer is technology, which shouldn't come as a
surprise because technology seems to be part of the answer to
every question these days.

"New technologies remain underutilized, and many banks are
struggling to make fundamental changes in their operating models
and embrace the potential benefits of digitization," the firm
wrote.

The report says digitization could deliver a 20% to 30%
improvement in profit, or an improvement of 2 to 3 percentage
points in return on equity, over three years. It encompasses
things like increased electronic trading, electronic onboarding
of clients, automation in back-office functions, big-data
analytics, and the use of public cloud infrastructure.

There are two potential strategies, McKinsey said: an all-in
approach, which makes sense for banks that are already tech savvy
and have a strong history in electronic trading, and a more
experimental and less expensive targeted approach. The chart
below shows the potential cost savings for these two groups.

"Not every digital investment will deliver a return (particularly
in the front office), but many of the digital tools and
technologies emerging today will become the foundational
infrastructure for a more streamlined and cost-effective
industry," the report said.